ACMB223 Management Accounting

BUDGETING FOR CONTROL AND BEHAVIOURAL ASPECTS OF MANAGEMENT ACCOUNTING

Learning Outcomes

At the end of this lecture, students should be able to:

• Prepare Flexible budget
• Explain the various approaches to budgeting and prepare each type of budget:
o Incremental budgeting
o Zero-based budgeting
o Rolling Budget
o Activity-based Budgeting
• Discuss on the management use of budget as target
• Discuss the effect of participation in budgeting on human behaviour
• Discuss bias in budgeting process
• Discuss the issues of accounting control techniques and performance evaluation
➢ Dysfunctional behaviour
➢ Accounting information for performance evaluation
➢ Educational role of the accountant

Introduction

• Control is the process of ensuring that firm’s activities conform to its plan and that its objectives
are achieved.
• The activities of planning and control are inter-related.
o Plans set the targets.
o Control involves two main processes.
➢ Measure actual results against the plan.
➢ Take action to adjust actual performance to achieve the plan or to change the plan
altogether.
• Control is therefore impossible without planning.

Flexible budget
• Budgeting is undertaken by most companies since it provides a basis for planning, control and
performance measurement.
• While a single approved budget emerges at the end of the budget process, a number of draft
budgets are often produced during that process.
• Some of these draft budgets will have considered different levels of sales since it is difficult to
estimate future market demand.

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• In order to produce draft budgets for different levels of demand, it is necessary to know how
costs and revenues behave at different levels of activity. Are costs fixed, variable or semi-
variable? Are sales prices affected by different levels of demand, changing economic factors
etc?
• The information gathered during the budget process can also be used to provide better control
information since it is highly unlikely that actual sales will be same as budget sales.
• Fixed budgets remain unchanged regardless of the level of activity, flexible budget are designed
to vary with the level of activity.

• Fixed budget
o A fixed budget is a budget which is designed to remain unchanged regardless of the volume
of output or sales achieved.
o The master budget prepared before the beginning of the budget period is known as the
fixed budget.
o The term fixed means:
▪ The budget is prepared on the basis of an estimated volume of productions and an
estimated volume of sales, but no plans are made for the event that actual volume of
production and sales may differ from budgeted volumes.
▪ When actual volumes of production and sales during control period
(month/week/quarter) are achieved, a fixed budget is not adjusted to the new/actual
levels of activity.

• Flexible budget
o A flexible budget is a budget which recognizes different cost behavior patterns to change
as volume of output changes.
o Flexible budgets may be used:
▪ At the planning stage. For example, suppose that a company expects to sell 10,000
units of output during the next year. A master budget (the fixed budget) would be
prepared on the basis of these expected volumes. However, if the company thinks that
output and sales might be as low as 8,000 units or as high as 12,000 units, it may
prepare flexible budgets at several different activity levels such as 8,000, 9,000, 11,000
and 12,000 units.
▪ Budgetary control – at the end of each month or year, the actual results of the
operation is compared with the flexible budget (budget flex based on the actual output
or sales)
o Preparing flexible budgets:
1. Determine the cost behavior patterns of each of the costs in the budget whether it
is fixed, variable, semi-variable or semi-fixed.
• Fixed cost – total cost remain the same at different level of activity. The unit fixed
cost decrease as activity level increases.
• Variable cost – the total variable cost increase proportionately with increase in
level of activity. The unit variable cost remains the same at different level of
activity.
• Semi-variable cost – unit semi-variable cost differ at different level of activity.
2. Re-calculate each of the costs based on the actual activity level.
• Variable cost = (budgeted variable cost ÷ budgeted units) x actual units
• Fixed cost = no change i.e use the same amount as in the budget.

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 • Semi variable - separate the variable and fixed element using high-low method or
any other appropriate method.
• Semi-fixed – separate the fixed and variable element of costs.

Example 1
The budgeted and actual results of Ridan Sdn Bhd for the month of October are as follows:
Budget Actual
Production units 15,000 14,000
RM RM
Material 570,000 536,000
Labour 225,000 220,00
Overhead 945,000 921,120
Total 1,740,000 1,677,120

The following information is applicable to the October results:

1. The budgeted labour costs consist of 30% fixed basic wages and the workers are paid
additional wages based on the units of product produced.
2. The overhead cost of the last 3 months were as follows:
Year Units RM
March 13,600 429,400
April 13,000 439,500
May 14,400 462,600
Required:

Prepare a flexible budget for October.

Flexible Budget October

Workings Flexible
Budget

Incremental Budgeting (IB)

• This is a budget prepared using a previous period’s budget or actual performance as a basis
with incremental amounts (fixed amount or a percentage) added for the new budget period
• Incremental budgeting is a reasonable procedure if current operations are effective, efficient
and economical as they can be.

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• It is also appropriate for budgeting for costs such as staff salaries, which may be estimated on
the basis of current salaries plus an increment for inflation and annual increment and are
administratively easy to prepare.
• In general, it is an inefficient form of budgeting as it encourages slack and wasteful spending
to creep into budgets.
• Past inefficiencies are perpetuated because costs levels are rarely subjected to close scrutiny.
• This approach is not recommended as it fails to take into account changing circumstances
• Moreover it encourages “spending up to the budget” to ensure a reasonable allocation in the
next period. It leads to a “spend it or lose” mentality.
• Typical usage: Government and not-for-profit organizations

Advantages
1. The budget is stable and change is gradual.
2. Managers can operate their departments on a consistent basis.
3. The system is relatively simple to operate and easy to understand.
4. Co-ordination between budgets is easier to achieve.
5. Conflicts should be avoided if departments can be seen to be treated similarly.
6. The impact of change can be seen quickly.
7. Suitable for organisations that operate in stable environment where historical figures are
reliable and are not expected to change significantly.

Disadvantages
1. The budget may become out of date and no longer relate to the level of activity or type of work
being carried out.
2. The priority for resources may have changed since the budgets were set originally.
3. Builds in previous problems and inefficiencies.
4. Managers may spend for the sake of spending in order to use up their budget for the year and
thus ensure that they get the same (or larger) budget next year.
5. There may be budgetary slack built into the budget, which is never reviewed-managers might
have overestimated their requirements in the past in order to obtain a budget which is easier
to work to, and which will allow them to achieve favourable results
6. Uneconomical activities may be continued. For example a car manufacturer may continue to
make parts in-house when it may be cheaper to outsource.

Example 2 (incremental budget - due to inflation):

LC Company bought 500 tons of material for its production process this year at a cost of RM2 per
ton. It expects production levels to increase by 20% next year and inflation of 5% is expected to
prevail. How much should LC budget in respect of material?

Budgeted materials
(500 tons x RM2) x 1.2 x 1.05 = RM1,260

Example 3
Sekolah Menengah Kebangsaan Muadzam Shah has a sizeable amount in its budget for staff
salaries. For the year 2017, staff salaries were RM1m. When the budget is being prepared for the
next year, the headmaster thinks that he will need to employ two new members of staff to teach

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mathematics, who will be paid a salary of RM30,000 per annum each and he will need to give all
staff members a pay increase of 5%. Calculate the budget for salary for 2018.

Answer:
Budgeted salary 2018 = (RM30k x 2) + (RM1m x 1.05) = RM1,110,000

Zero-Based Budgeting (ZBB)

• Description: A budget that requires management to start at zero and estimate all expenses as
a new operation.
• Start each budget period afresh-not based on historical data
• Budgets are zero unless managers make the case for resources-the relevant manager must
justify the whole of the budget allocation
• It means that each activity is questioned as if it were new before any resources are allocated
to it.
• Each plan of action has to be justified in terms of total cost involved and total benefit to accrue,
with no reference to past activities.
• Resources are not necessarily allocated in accordance with previous patterns and
consequently each existing item of expenditure has to be annually re-justified.
• ZBB is designed to prevent increasing budgets each year with inflation
• Typical usage: Organizations focusing on cost reduction and evaluating efficiency

Implementing ZBB
• Steps involved in zero base budgeting
1. Identification of decision units
2. Development of Decision packages
3. Review and ranking of decision making

Identification of decision units

 A specific manager should be clearly responsible for the operation of the program.
 It must have well defined & measurable impacts.
 It must have well defined & measurable objectives.
 Identify and describe a particular activity.
 After the identification of appropriate decision units, the next step is to prepare for each of
these a document describes the objectives or purposes of the decision unit and the actions
that could be taken to achieve them. Such document is called “Decision Package”.

Development of Decision packages

1. Mutually exclusive – Contains alternative ways of doing a job.
2. Incremental – Defining different levels of efforts
• Decision packages will have work packages - Costs, returns, purpose, expected results,
alternatives available, consequences if activity is not performed or reduced.
• Example - Opening a Hospital
– Staff (Doctors, Nurses…)
– Equipments and increased staff
– Emergency beds and less normal beds

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 – Increasing beds and other facilities

Review and ranking of decision making

 Once the decision packages have been prepared, they are ranked on an ordinal scale i.e
1st, 2nd, 3rd, etc in order of priority using Cost benefit Analysis.
 Decide whether to accept or reject or amend the activity.

Using ZBB
• Useful for budgeting for discretionary costs and for rationalisation purposes. Best applied to
support expenses that are expenditure incurred in departments which exist to support the
essential production function such as marketing, finance, quality control, personnel, data
processing, sales and distribution.
• In many organisations, these support departments make up a large proportion of the total
expenditure.
• These activities are not easily quantifiable by conventional methods and are more
discretionary in nature.
• Not suitable for direct manufacturing costs, which are usually budgeted using standard
costing, work study and other management planning and control techniques.
• Suitable for service industries and non-profit-making organisations such as local and central
government departments, educational establishments and hospital.
• Can be used for rationalisation decisions- cutting back on production and activity levels, and
cutting costs.

Advantages
1. ZBB documentation provides an in-depth appraisal of an organisation’s operation.
2. Forces budget setters to examine every item and it challenges the status quo.
3. Allocation of resources linked to results and needs.
4. Develops a questioning attitude.
5. Forces employees to avoid wasteful expenditure.
6. Can increase motivation.
7. It responds to changes in the business environment.
8. Encourages managers to look for alternatives.
9. More efficient allocation of resources.

Disadvantages
1. It a complex time consuming process
2. Short term benefits may be emphasised to the detriment of long term planning.
3. Affected by internal politics - can result in annual conflicts over budget allocation.
4. Organisation’s information systems may not be capable of providing suitable information.

Rolling Budget (Continuous Budget)

• Budgets which are continuously updated by adding a further accounting period (a month or a
quarter) when the earlier accounting period has expired.
• Dynamic conditions:

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 o Actual condition may differ from those anticipated when the budget was drawn up for a
number of reasons.
o Organizational changes may occur:
1. A change in structure, e.g. from a functional basis to process-based structure.
2. New agreements with the workforce about flexible working or safety procedures.
3. The reallocation of responsibilities following the removal of middle management and
the empowerment of workers further down the line.
o Action may be needed to combat an initiative by a competitor.
o New technology may be introduced to improve productivity, reduce labour requirements
or enhance quality.
o Environmental conditions may change: there may be a general boom or recession, an
event affecting supply or demand, or a change in government policy.
o Level of inflation may be higher or lower than anticipated.
o The level of activities may be different from the levels planned.
• Any of these changes may make the original budget quite inappropriate, either in terms of the
numbers expected, or the way in which responsibility for achieving them is divided, or both.
• Rolling budgets are attempt to prepare targets and plans which are more realistic and certain,
particularly with regard to price levels, by shortening the period between preparing budgets.
• Instead of preparing a periodic budget annually for the full budget period, there would be
budgets every 1,2,3 or 4 months (3-6, or 12 months each year). Each of these budgets would
plan for the next 12 months so that the current budget is extended by an extra period as the
current period ends: hence the name rolling budgets.
• Suppose, a rolling budget is prepared every 3 months. The 1 st 3 months of the budget period
would be planned in great detail, and the remaining 9 months in lesser details, because of the
greater uncertainty about the longer-term future.
The Rolling Budget Preparation (every 3 months):

January – March →detail

April – December → less detail
New budget

April – June →detail

July – March → less detail
New budget

July – September →detail

October – June → less detail
New budget

October – December →detail

January– September → less detail

Advantages
1. They reduce the element of uncertainty in budgeting because they concentrate detailed
planning and control on short-term prospects where the degree of uncertainty is much smaller.
2. They force manages to reassess the budget regularly, and to produce budgets which are up to
date in the light of current events and expectations.
3. Planning and control will be based on a recent plan which is likely to be far more realistic than
a fixed annual budget made many months earlier.
4. Realistic budgets are likely to have a better motivational influence on managers.
5. There is always a budget which extends for several months ahead. For example, if rolling
budgets are prepared quarterly there will always be a budget extending for the next 9-12
months. This is not the case when fixed annual budgets are used.

Disadvantages

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1. Involve more time, effort and money in budget preparation.
2. Frequent budgeting might have an off-putting effect on managers who doubt the value of
preparing one budget after another at regular interval.
3. Revisions to the budget might involve revisions to standard costs too, which in turn would
involve revisions to stock valuations. This could replace a large administrative effort from the
accounts department every time a rolling budget is prepared.

Example 4
A company uses a system of rolling budgets. The sales budget is displayed below:

Jan – Mar Apr – Jun (RM) July-Sept (RM) Oct-Dec (RM) Total (RM)
(RM)
Sales 78,480 86,120 91,800 97,462 353,862

Actual sales for January-March were RM74,640. The adverse variance is explained by growth being
lower than anticipated and the market being more competitive than predicted.

Senior management has proposed that the revised assumption for sales growth should be 2.5%
per quarter.

Required:
Update the budget where appropriate.

Answer:
Step 1:
The revised budget should incorporate 2.5% growth starting from the actual sales figure for
January-March = RM74,640 x 1.025 = RM76,506

Step 2:
Using the revised balance for January-March, update the budget for the next four quarters
(including a figure for January-March of the following year)
Apr – Jun = RM76,506 x 1.025 = RM78,419
July-Sept = RM78,419 x 1.025 = RM80,379
Oct-Dec = RM80,379 x 1.025 = RM82,388
Jan – Mar = RM82,388 x 1.025 = RM84,448

Activity-Based Budgeting (ABB)

• Definition: A method of budgeting based on an activity framework and utilising cost driver
data in the budget-setting and variance feedback processes.
• Or, put more simply, preparing budgets using overhead costs from activity based costing
methodology.
• ABB involves defining the activities that underlie the financial figures in each function and
using the level of activity to decide how much resource should be allocated, how well it is
being managed and to explain variances from budget.

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• Conventional budgeting is inappropriate for those activities where the consumption of
resources does not vary proportionately with the volume of the final output of products or
services.
• For support activities conventional incremental budgets merely serve as authorization levels
for certain levels of spending.
• Incremental budgeting results in the cost of non-unit level activities becoming fixed.
• ABB aims to authorize only the supply of those resources that are needed to perform activities
required to meet budgeted production and sales volumes.

ABB involves the following stages:

1. Estimate the production and sales volume by individual products and customers.
2. Estimate the demand for organizational activities. (e.g. Process 5,000 customers’ orders for the
customer order processing activity)
3. Determine the resources that are required to perform organizational activities. (e.g. 0.5 hours
per order = 5,000 × 0.5 hours = 2,500 labour hours for the customer processing activity must
be supplied)
4. Estimate for each resource the quantity that must be supplied to meet the demand. (e.g.
assume a step cost function with each person employed contracted to work 1,500 hours per
year so that quantity of resources required = 2,500/1,500 =1.67 persons meaning that 2
persons must be employed)
5. Take action to adjust the capacity of resources to match the projected supply. (e.g. If 3 persons
are presently employed on the activity resources must be reduced, or redeployed, by one
person)
6. Periodically actual results should be compared with an adjusted (flexible) budget.

Advantages:
1. Different activity levels will provide a foundation for the base package and incremental package
for ZBB.
2. It will ensure that the organisation’s overall strategy and any actual or likely changes in that
strategy will be taken into account, because it attempts to manage the business as the sum of
the interrelated parts.
3. Critical success factors will be identified and performance measures devised to monitor
progress towards them. (A critical is an activity in which a business must perform well if it is to
succeed)

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4. Because concentration is focused on the whole of an activity, not just its separate parts, there
is more likelihood of getting it right first time. For example what is the use of being able to
produce goods on time for their despatch date if the budget provides insufficient resources for
the distribution manager who has to deliver them?
5. It draws attention to the costs of 'overhead activities' which can be a large proportion of total
operating costs.
6. It recognises that it is activities which drive costs. If we can control the causes (drivers) of costs,
then costs should be better managed and understood.
7. ABB can provide useful information in a total quality management (TQM) environment, by
relating the cost of an activity to the level of service provided.

Disadvantages:
1. A considerable amount of time and effort might be needed to establish the key activities and
their cost drivers.
2. It may be difficult to identify clear individual responsibilities for activities.
3. It could be argued that in the short-term many overhead costs are not controllable and do not
vary directly with changes in the volume of activity for the cost driver. The only cost variances
to report would be fixed overhead expenditure variances for each activity.

Example 5
Eranium Engineering Ltd makes four types of air-compressor, the HP100, HP200, LP30 and LP60.
The company introduced ABC several years ago. It is now planning to introduce ABB. Set out below
is a summary of the information extracted from the ABC system concerning materials handling.
▪ Cost pool for the materials handling activity in the last year, RM75,000.
▪ Cost driver is the number of materials movements.
▪ Total number of materials movements in the last year, 15,000
The relevant product information is:
Product HP100 HP200 LP30 LP60
Budgeted output in the coming year (units) 3,000 8,000 2,500 4,800
Standard batch sizes (units) 15 20 5 15
Standard materials movements per batch 5 6 13 8

Required
Calculate:
(i) the budgeted cost pool for materials handling in the coming year.
(ii) the standard handling cost per unit for each product.
Use last year’s actual figures for the materials handling cost pool and the number of materials
movements as your basis.

Solution
(i) The standard ABC per materials movement, based on last year’s actual figures,

Cost driver rate = Budgeted Cost pool ÷ Budgeted quantity of cost driver = RM75,000 ÷ 15,000 =
RM5 per materials movement.

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 Product HP100 HP200 LP30 LP60 Total
Budgeted output in the coming 3,000 8,000 2,500 4,800
year (units)
÷ Standard batch sizes (units) 15 20 5 15
= budgeted batches 200 400 500 320
(x) Standard materials 5 6 13 8
movements per batch
= budgeted material movement 1,000 2,400 6,500 2,560 12,460
(x) RM5 = Budgeted material 62,300
handling cost pool (RM)
Standard materials movements 5 6 13 8
per batch
(x) RM5 = standard materials 25 30 65 40
movements per batch (RM)

(b) Reasons why the actual cost pool may differ from the ABB in the coming year.
• The batch sizes may differ from the budget.
• The number of materials movements per batch may increase or decrease.
• The output of each product may differ from budget.
• The cost pool may be affected by price changes and labour rate changes.
• The efficiency with which the materials handling activity is carried out may improve or
deteriorate.

The Use of Budgets as Targets

1. The existence of a defined, quantitative goal or target is likely to motivate higher levels of
performance than when no such target is stated.
2. People perform better when they have a clearly defined goal to aim for and are aware of the
standards that will be used to evaluate their performance.
3. In an ideal situation the goals of the organisation will equate to those of the individual
responsible for their achievement. This is argued will lead to motivational benefits with the
likelihood that the targets will be achieved.
4. For the motivational effect to work, the target set must be achievable but not being too easy.
If too easy to achieve, the individual may see it as demeaning, and not make any effort to
achieve it. This has a de-motivating effect and is worse than having no target at all.
5. Otley (1987) shows the relationship between budget difficulties, aspiration levels and
performance (refer figure below). When budget difficulty is increased both the budgettee’s
(person responsible for the budget) aspiration level and performance increases. However,
there become a point where the budget is perceived as impossible to achieve and the
aspiration level and performance decline dramatically.
6. To motivate the best level of actual performance, demanding budgets should be set and small
adverse variances should be regarded as a healthy sign and not something to be avoided. If
budgets are always achieved with no adverse variances, this indicates that the standards are
too loose to motivate the best possible result.
7. Therefore, it is necessary to identify the aspiration level of individual before setting the budget
so as to ensure goal congruence and encourage motivational aspects.
8. Ideal target – slightly above the anticipated performance level

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9. Budget set to maximise performance is likely to create adverse variances – to be managed
carefully & central management must accept that the budget is unlikely to be achieved
➢ Target should:
• Communicated in advance
• Dependent on factors controllable by the individual
• Based on quantifiable factors
• Linked to appropriate rewards & penalties
• Chosen carefully to ensure goal congruence

10. Arguments in favour of setting highly achievable budgets

• Conflict between planning & motivational purposes.
• Psychological benefits (e.g. achievement & self-esteem).
• Shields managers from adverse impact of environmental changes.
• Alleviates harmful side-effects of controls.

Participation in budgeting process

1. Participation relates to the extent that subordinates or budgetees are able to influence the
figures that are incorporated in their budgets or targets.

2. Top-down budget setting – consistent with Douglas McGregor’s Theory X view that people in
work environment are basically lazy and dislike work and any responsibility associated with it.

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 They are motivated by money to meet their basic needs. Therefore, the Theory X style of
management is authoritarian, based on direction and control down through the organisation
and typified by a host of rules and regulations.

3. Bottom-up budget setting – consistent with Theory Y view that people in a work environment
do seek more responsibility and do not have to be so tightly controlled. Therefore, Theory Y
style of management predominates that employees are more likely to cooperate and strive to
achieve the targets if they participate in setting up the budget.

4. Advantages of participation in the setting of performance standards:

a) Targets more likely to be accepted
b) Reduces the information asymmetry gap (subordinates have more information on the
relationship between inputs and outputs, whereas superiors have a broader view of the
organisation as a whole)
c) Reduces negative attitudes and dysfunctional behaviour (demotivation and alienation)

5. There are limitations on the extent of the effectiveness of participation in the budget-setting
process especially if budgets are used both in motivational role and evaluation of managerial
performance. A manager through participation may be able to influence the budget (e.g. by
lowering the target) which is subsequently used to evaluate him.

6. Empirical studies provide conflicting evidence on the effectiveness of participation.

7. Factors influencing the effectiveness of participation:

a) Personality variables:
✓ Authoritarianism – participation is ineffective for highly authoritarian people.
✓ Locus of control (the degree to which individuals feel they have control over their own
destiny) – participation is effective for people who felt that they had a large control
over their destiny (i.e. confident people)
b) Work situation – participation is less effective for environment which is highly
programmed, environmentally and technologically constrained areas, where speed and
detailed control are essential for efficiency.
c) Job difficulty – performance was found to be high when the amount of participation was
proportionate to the level of job difficulty.

Bias in budgeting process

1. Budget bias or budget slack is the process of building room for manoeuvre when setting a
budget by overstating the level of budget expenditure or by understating the level of budgeted
sales.
2. The possible reasons for creation of the budget bias:
a) It should lead to the most favourable result when actual is compared with budget. Such a
result should lead to the optimisation of personal gain for the individual manager.
b) Where reward structures are based on comparison of actual with budgeted results, bias
can help to influence the outcome.
c) In an uncertain business environment it is a way of relieving some of the pressures of a
tight situation. The bias will allow some leeway if things do not go according to plan.

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 d) Some people may see the creation of bias in a budget as a way of “legally” beating the
system. A manager may regard the creation of bias as a desirable personal objective and
success in achieving it as motivational towards the best actual performance.

3. Budget bias can sometimes be in opposite direction such as marketing manager overstating
budgeted sales to please senior management or a manager with previously weak performance
may wish to show promising future situation in order to gain approval from his superior. The
short-term approval will usually be at the risk of future disapproval if the optimistic result is
not reflected in the actual results.

4. Budget bias can be good if it has the effect of motivating manager to his best actual
performance and bad if it is use to make forecasts and as a basis of consequent major decisions
which will lead to erroneous decision.

Issues of accounting control techniques and performance evaluation

Dysfunctional behaviour
1. There may be general fear and misunderstanding about the purpose of budgetary control
which is often regarded as a penny-pinching exercise rather than as a tool of management at
all levels of an organisation structure. If this tends to be the attitude, a carefully planned
campaign of education and understanding should be undertaken.
2. Employees may become united against management and devote their energies to finding
excuses for not meeting targets. Therefore organisation should set targets that are seen by
employees to be realistic.
3. The breaking down of organisation into many sub-areas of managerial responsibility can lead
to sub-optimisation problems as far as the whole company is concerned i.e. the optimisation
of an individual manager’s department or section at the expense of the organisation overall. It
reflects a lack of goal congruence.
a) Data manipulation occurs where individuals try and distort the data in order to improve
the perfor mance measure by deliberately building slack in the budgets to obtain easier
targets. Merchant (1990) also reported widespread use of shifting funds between different
budget items in order to avoid adverse budget variance.
b) There is a danger that subordinates will concentrate only on what is measured, regardless
of whether or not it is organisationally desirable.
c) Tendency for results controls to focus mainly on controlling behaviours that are
quantifiable and easily measurable and ignore those behaviours that are less quantifiable.
d) If controls are applied too rigorously they can result in job-related tension, conflict and
deterioration in relationship with managers and possibly other colleagues.

Accounting information for performance evaluation

1. It is a common practice to attempt to assess the performance of a manager by a comparison
of budgeted and actual results for his area of responsibility.
2. The choice of which particular measures to use is important to ensure that the individual
manager sees the attainment of his target as worthwhile for himself and at the same time in
the best interests of the organisation as a whole. In practice, conflicts can and often do arise
between individual manager’s personal objectives and those of the organisation as a whole.
3. The way in which the information in budget reports is used in the assessment of managerial
performance has to be considered carefully. Over-emphasis on results may lead to pressure

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 and feelings of injustice from the system, and too little stress on results may lead to budget
irrelevancy attitude and low morale.
4. A study by Hopwood (1976) based on observations in a manufacturing division of a large US
steel company identified three styles of using budget/actual cost information in the evaluation
of managerial performance:
a) Budget constraint style
✓ The primary emphasis is on the evaluation of a manager’s performance in terms of
meeting the budget in the short term.
✓ It resulted in a great involvement in costs and cost information and high-degree of job-
related pressure and tension. It often led to the manipulation of data for inclusion in
accounting reports. Relations with both colleagues and superior were poor.

b) Profit conscious style

✓ Performance is measured in terms of the ability to increase the overall effectiveness
of the area of responsibility in the context of meeting the longer-term objectives of
the organisation.
✓ At cost centre levels of responsibility, the reduction of long-run average costs could be
seen as achieving the objective. Short-term budgetary information needs to be used
with care and in a flexible way to achieve this purpose.
✓ It showed good relations with colleagues and superiors. There was still a high
involvement with costs but less job-related pressure. Consequently, the manipulation
of accounting data was reduced.

c) Non-accounting style
✓ Evaluation is not based on budgetary information. Accounting information plays a
relatively unimportant role but other non-accounting performance indicators are
more important.
✓ Similar effect as profit conscious style except lower impact of costs and cost
information on manager. Both styles showed better managerial performance whereas
budget constrained style showed poor performance.

5. Otley (1978) did similar study in the UK showed closer linked between the budget constrained
style and good performance. The managers evaluated on a rather tight budget constrained
basis tended to meet the budget more closely than if it was evaluated in a less rigid way.
6. The different results were due the different organisational environment. The US study involved
highly interdependent cost centres in a highly integrated production function; the UK study
involved largely independent profit centres. Therefore, any generalisations about evaluation
styles must take into account the contingent variables associated with differing organisational
structure.
7. Educational role of the accountant – good communications involving consultation and
discussion with all levels of management and other employees should be able to minimise the
behavioural problems.

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 Tutorial Exercises
Question 1
Perusahaan Bersatu Sdn Bhd manufactures one product whose output level varies from month to
month. No inventory is held. Budgets for its minimum and maximum monthly output levels are
given below, together with actual figures for June 2017.

Cost classification Budgeted Budgeted Actual

minimum maximum
Output (units) 20,000 40,000 35,000
RM RM RM
Sales revenue 400,000 800,000 735,000
Less:
Direct materials variable cost 240,000 480,000 430,000
Direct labour variable cost 50,000 100,000 80,000

Indirect labour semi-variable cost 15,000 25,000 31,000

Indirect materials fixed cost 6,000 6,000 6,500
Profit 89,000 189,000 187,500

Required:
(a) Prepare a flexed budget for an output level of 35,000 units and calculate revenue, cost and
profit variances for June 2017.

(b) Several assumptions are commonly made by accountants when preparing or interpreting
budgetary information. Explain why each of the following assumptions might be made by
accountants when designing a system of budgeting, and to set out in each case also any
arguments which, in your view, raise legitimate doubts about their validity.
(i) Budgeted performance should be reasonably attainable but not too easy.
(ii) Participation by managers in the budget setting process leads to better performance.

Question 2
The managing partner of Rozelle Sdn. Bhd. has become aware of the disadvantages of static
budget. She has asked the new management accountant to prepare a flexible budget for November
2015. The statement for November for the production department is shown below:

Direct labour Direct labour Direct material Utilities (RM)

hours (RM) (RM)
Budget 9,600 77,955 336,000 60,880
Actual 10,710 87,341 309,000 65,763

Additional information about the budget:

1. The budgeted and actual direct labour costs include the fixed salary of RM5,955 for the Manager
of the Production Department. All of the other direct labour is paid for the hours they work.
2. The direct material costs vary in proportion with direct labour hours worked.
3. The record for July to October shows the following:

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 Direct labour hours Utilities (RM)
July 9,500 56,850
August 11,200 68,360
September 9,000 57,700
October 13,700 82,610
4. The actual fixed costs for November were as budgeted.
Required:
Prepare a flexible budget for November.

[10 marks]

Question 3
The managing partner of Classic Music Box Sdn Bhd has become aware of the disadvantages of
static budget. She has asked the new management accountant to prepare a flexible budget for
October 2013. The statement for October for the production department is shown below:

Budget Actual
Direct labour hours 9,600 10,710
RM RM
Direct labour 77,955 87,341
Direct material 336,000 309,000
Utilities 60,880 65,763
Other production overheads 93,090 168,510

Additional information about the budget:

1. The budgeted and actual direct labour costs include the fixed salary of RM5,955 for the
Manager of the Production Department. All of the other direct labour is paid for the hours they
work.
2. The direct material costs vary in proportion with direct labour hours worked.
3. The record for June to September shows the following:

Direct labour hours Utilities (RM)

June 9,500 56,850
July 11,200 68,360
August 9,000 57,700
September 13,700 82,610

4. The budgeted other overhead costs are made up of three elements; a fixed cost of RM13,500
for services from central headquarters, stepped fixed cost which changes when the direct
labour hours exceed 10,500 hours, and some variable overheads. The variable overheads are
assumed to vary in proportion to the direct labour hours. Working paper for the budget
showed the impact on the overhead costs of differing amounts of direct labour hours.
Assembly labour hours 7,500 11,250 15,000
Other overhead costs (RM) 81,750 114,750 135,000
The actual fixed costs for October were as budgeted.

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Required:
Prepare a flexible budget for October.

Question 4
Iskandar Fleet (IF) is a division that operates transportation services for Jaewoo Corp. (JC), a foreign
owned company based in Nusajaya. A fleet of motor vehicles are utilised specifically to transfer
managerial level staff throughout Malaysia to attend official functions such as meetings and
conferences. At present, it operates with 25 vehicles until the end of July, when it expects to
acquire an additional motor vehicle. The fleet is self-sufficient, in that it provides for petrol

consumption and in-house maintenance.

A mechanic is employed to perform routine maintenance and minor repairs, whilst major repairs
will be done by a local garage.

Each year Mr. Ravi, the supervisor prepares and presents an operating budget to the top
management on funds required to operate the fleet. Depreciation on the motor vehicles is
recorded in the budget in order to determine the cost per kilometer (km).
The following is the annual budget approved by Jaewoo. The actual costs for August are compared
with a monthly budget derived from the annual budget.

The annual budget was constructed based on the following assumptions:

1. There are 25 motor vehicles in the fleet.
2. It is estimated that each motor vehicle runs 60,000 kms per year and consumes a litre of
petrol for every 8 kms.
3. The petrol rate is RM0.44 per litre.
4. In-house maintenance costs include oil, minor repairs, parts and supplies. The cost of in-
house maintenance is RM0.01 per km.
5. Iskandar Fleet made an agreement to send its’ vehicles that require major repairs to a local

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 garage. These outside repairs will cost RM108 per motor vehicle for every repair completed.

Mr. Ravi is upset with the performance report prepared by the finance department for the month
of August, which compares budget and actual costs. He argues that it reports his performance
unfairly. Mr. Ravi suggests the use of flexible budgeting as it is widely used to compare actual costs
with budgeted amounts.

Required:

(a) Is Mr. Ravi’s argument about the unfairness of Iskandar Fleet’s original performance report
warranted? Explain.
(b) Prepare a performance report for August 2015 that would provide a more realistic
indication of the variances.
(c) It is stated that Mr. Ravi prepares and presents yearly operating budget to the top
management on funds required to operate Iskandar Fleet. This indicates that Jaewoo Corp.
encourages managers’ participation in budget-setting.
Participation relates to the extent that subordinates are able to influence the figures that
are incorporated in their budgets or targets. Discuss THREE (3) advantages and
disadvantages of participation in setting of budgets.

Question 5
(a) ‘A zero-based budgeting system involves establishing decision packages that are then
ranked in order of their relative importance in meeting the organisation’s objectives’.
Explain the statement and the difficulties that a not-for-profit organisation may experience
when trying to rank decision packages.

(b) “Public sector organisations are responsible for taxpayers’ money therefore they should
no longer be allowed to use incremental budgeting but should instead use a zero based
budgeting system”. Explain THREE (3) advantages and TWO (2) disadvantages of public
sector organisations using zero based budgeting.

Question 6
A firm of solicitors is using budgetary control during 2010. The senior partner estimated the
demand for the year for each of the firm’s four divisions: Civil, Criminal, Corporate and Property. A
separate partner is responsible for each division.

Each divisional partner then prepared a cost budget based on the senior partner’s demand
estimate for the division. These budgets were then submitted to the senior partner for his approval.
He then amended them as he thought appropriate before issuing each divisional partner with the
final budget for the division. He did not discuss these amendments with the respective divisional
partners. Actual performance is then measured against the final budgets for each month and each
divisional partner’s performance is appraised by asking the divisional partner to explain the reasons
for any variances that occur.

The Corporate partner has been asked to explain why her staff costs exceeded the budgeted costs
for last month while the chargeable time was less than budgeted. Her reply is below:

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 ‘My own original estimate of staff costs was higher than the final budgeted
costs shown on my divisional performance report. In my own cost budget I
allowed for time to be spent developing new services for the firm’s corporate
clients and improving the clients access to their own case files. This would
improve the quality of our services to clients and therefore increase client
satisfaction. The trouble with our present system is that it focuses on financial
performance and ignores the other performance indicators found in modem
performance management systems.’
Required:
(a) Discuss the present budgeting system and its likely effect on divisional partner motivation.

(b) Explain two non-financial performance indicators (other than client satisfaction and service
quality) that could be used by the firm.

Question 7
Discuss the behavioural arguments for and against involving those members of management who
are responsible for the implementation of the budget in the annual budget setting process.

Question 8
Letronic Sdn Bhd manufactures and sells electronic components to electronics stores. Ranbir, the
controller, is preparing his annual budget and has asked the sales group to prepare sales estimates.
All members of the sales force have been asked to estimate sales in their territory for each of the
organisation’s five major products.

The marketing group is paid a salary and a commission based on sales in excess of some target
level. Ranbir discovered that the sales manager uses the sales estimates to develop the target levels
at which commissions begin. Specifically, the sales manager takes the sales estimate, adds 10%,
and the result becomes the sales hurdle level. If sales are less than the hurdle level, no commissions
are paid. If sales is above the hurdle level, commissions are paid at varying rates.

Required:
(a) Discuss the motivation and consequence of basing the organisation’s budgets on the
estimates.

(b) Discuss approaches that Ranbir can introduce to alleviate dysfunctional behaviours in budget
setting of the sales force at Letronic Sdn Bhd.

Question 9
EQ is a retail company that operates six stores. Each store has a manager and there is also a General
Manager who reports directly to the Board of directors of the company. For many years the
General Manager has set the budgets for each store and the store managers’ performances have
been measured against their respective budgets even though they did not actively participate in
their preparation. If a store manager meets his budgeted target then he is financially rewarded for
his performance. The company has recently appointed a new Finance Director who has questioned
this previous practice and suggested that each store manager should be involved in the preparation
of their own budget. The General Manager is very concerned about this. She thinks that the store

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managers will overstate their costs and resource requirements in order to make it easier for them
to achieve their budget targets.

Required:
(a) Explain the problems that could arise, for planning and decision-making purposes within
EQ, if the store managers did overstate their budgeted costs and resource requirements.

(b) Discuss the behavioural issues that could arise if excess costs and resources are removed
from the store managers’ budgets.

Question 10
Bobson Consultancy & Accounting Services (BCAS) provides accounting services to small
businesses. The following data relate to the preparation for the draft of flexible budget for the next
period.
1. The average annual salary of the 12 consultants employed by the company is RM60,000
per annum.
2. Freelance consultants will be paid RM60 per hour.
3. The average charge out rate to clients for the company’s consultants is expected to be
RM100 per hour. However, this rate will increase by 10% if the company’s consultancy
work exceeds 18,000 hours since the company will employ freelance consultants for the
additional work. The premium only applies to work in excess of 18,000 hours.
4. The following inflation adjusted analysis of office expenses was obtained for the last three
years:
Hours 14,000 16,000 17,000
Office expenses RM720,000 RM750,000 RM780,000

5. Travel and subsistence expenses are expected to average RM10 per chargeable consulting
hour.

The managing director of BCAS has asked the management accountant to prepare budget for three
projected levels of activity.

Required:
(a) Prepare a flexible budget for the three projected level of activity at 17,000, 18,000 and
19,000 hours.
[11 marks]
(b) Distinguish between static and flexible budgets and explain the benefit of using a flexible
budget.
[3 marks]

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 Question 11

a) Discuss the impact of level of budget difficulty on motivation and performance.

b) Mobile Car Wash provides on-site car wash services in Muadzam. Zaidi Syafiq, the manager
was visibly upset after being scolded for his department’s poor performance over the
month of June, 2017. The department’s cost control report is given below:

Budget Actual Variances

Labour hours 8,750 9,500
RM RM
Direct labour wages 20,125 21,525 1,400A
Supplies 5,250 5,775 525A
Utilities 3,800 3,925 125A
Maintenance 33,500 34,325 825A
Supervision 9,500 10,500 1,000A
Depreciation 20,000 24,000 4,000A
Total 92,175 100,050 7,875A

Additional information:
1. Direct labour wages and supplies are variable costs,
2. Supervision and depreciation are fixed costs,
3. Maintenance is mixed cost with the fixed component cost of RM23,000.
4. The following analysis of utilities expenses was obtained for the last three month:
Month March April May
Labour hours 7,050 7,570 8,250
Utilities expenses RM3,630 RM3,682 RM3,750

Required:

1. Should Zaidi Syafiq feel upset with the department’s cost control report? Explain?
[3 marks]
2. Prepare a new performance report that will help Zaidi Syafiq’s top management assess
how well costs were being controlled in his department.
[12 marks]

3. Do you think any of variances in the report should be investigated? Why?

[3 marks]

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